Over the past few months, the market has climbed upwards relatively quickly, which has eliminated a lot of the deep bargains available. There are still some great deals out there and I’ve been fortunate enough to discover a few, but it’s become much more difficult to find stocks with the highly favorable risk-reward balances we saw earlier this year.

One sector where I believe huge opportunities have opened up is small commercial banks. These are not the Banks of America (BAC), the Citigroups (C), or even large regional players like SunTrust (STI) and Regions Financial (RF). Rather, these are often community banks or small regional banks that may operate in a few metropolitan areas.

There is an unbelievable amount of bearish sentiment in regards to these banks due to the fact that (a) the government is not going to pull out all stops to save them like their “too big to fail” peers, (b) the FDIC seems to shut down another obscure commercial bank every Friday, and (c) these banks are less closely followed by the investing masses. Essentially, investors are scared out of their pants at the mere thought of owning a small commercial bank, so few bother to research them, but that’s why there’s great opportunity in the sector.

There’s also a silent factor working in favor of the banks here --- 0% interest rates! It’s essentially a gift from the Feds and we’re probably going to see rates stay low for the near-term future. Not all is rosy, however. The FDIC’s woes mean that all the surviving banks are being forced to subsidize the failing banks with higher premiums. These special charges from the FDIC are having a significantly negative impact on earnings for the banks. This is both bad and good for opportunistic investors --- these charges hurt the banks, but they should level off as the system regains its footing, which means bank earnings are going to surprise people at some point.

There is considerable risk in this sector. If you are afraid of losing 50% of your investment in the next few months, then you should keep far, far away. On the other hand, if you’re willing to stay on for the ride, the rewards at the end of the rainbow could be quite plentiful.

Bank Portfolio Criteria

Of course, buying into small commercial banks blindly would be foolish. Rather, I’ve been looking for a few different factors when seeking out these banks:

(1) Lower to moderate leverage when compared to other commercial banks

(2) Less exposure to the huge bubble markets

(3) Revenues are increasing, staying the same, or not significantly declining

(4) Market share is increasing

(5) Interest margins are strong/increasing

(6) Inside ownership

(7) Insiders have made significant buys

(8) Strong earnings potential, and most importantly,

(9) Stock price offers very highly favorable risk-reward balance

I don’t expect to be right on my entire set of bank picks. Rather, my belief is that the gains from the biggest winners will easily offset the losses from the biggest losers. Keep that in mind.

I’ve identified a few opportunities in the sector. The first one I want to explore is Hampton Roads Bankshares (HMPR), which could arguably meet all nine attributes above, or at least most of them.

Gateway Bank is headquartered in Raleigh, NC, with branches in the Research Triangle, Eastern North Carolina, Southeastern Virginia, as well as Richmond, VA and Charlottesville, VA. Shore Bank operates exclusively in the Eastern Shore region of Virginia and Maryland. HMPR’s collective banks engage in community and commercial banking services and target their offerings to individuals, as well as small and medium sized businesses. HMPR is involved with constructive and real estate loans, an area of some fear amongst investors.

At the end of 2008, HMPR and Gateway Financial Holdings were approved to participate in TARP. HMPR briefly issued a common share offering in August, but ended up withdrawing the offer, probably due to unfavorable market conditions. This means investors should definitely be on the lookout for another common share offering if the stock creeps back over the $5 - $7 range.

Balance Sheet

On the face of it, HMPR’s balance sheet appears to be in reasonable shape. They have less leverage than some of their peers and there’s no indication I can see that the quality of their loan portfolio is below the national average. However, they still could use a larger equity cushion and for common shareholders, the annoying aspect might be the feeling that one is outflanked by other interests.

Note that “Total Liabilities” are about 90.2% of “Total Assets”, with about 2.2% being in “Intangible Assets.” After discounting intangibles, the Liability to Tangible Assets ratio is about 92.3%. This is a bit higher than I would like to see, but about par for the course when it comes to commercial banks.

From HMPR’s most recent FDIC filing, here are their leverage and capital ratios:

Those figures held steady for the most recent quarter. Digging back further into FDIC filings, it appears that HMPR’s current leverage is more reflective of Gateway Bank’s old ratios rather than the Bank of Hampton Roads’ old ratios, which dropped significantly upon the merger.

The allowance for loan losses is equal to about 3.95% of HMPR’s loan balance. I wanted to see how equity and Net Tangible Assets (NTA) would be affected in the event that HMPR’s delinquent loans were either lower or higher than the allowance. The below chart is my attempt to do that:

While the above chart is far from a scientific analysis, there is a lot to dislike about it all the same. In spite of HMPR’s 8.6% Tier 1 Leverage ratio, adjusted tangible common equity can get ugly in the event of much further stress to HMPR’s loan portfolio. It is difficult to say whether the allowance has peaked or not, but if we assume that 5.5% represents the “true value”, then the stock actually trades very close to CTE per share right now. All the same, the chart does suggest that HMPR’s capital cushion is large enough to absorb some significant further losses.

Earnings Potential

After looking at the Balance Sheet, we need to find out whether this bank is profitable or at least has the potential to be reasonably profitable in the future. All the banks are going to suffer to some extent through this deleveraging period, but some are going to earn their way out of it and some are going to benefit in the long-term as a result of it.

Unfortunately, discovering HMPR’s earnings potential is not a simple task. It is made difficult by the acquisition of Shore Bank and Gateway Bank. We can take a look at HMPR’s past financials to better understand the profitability picture of the Bank of Hampton Roads:

As you can see from above, the Bank of Hampton Roads has had a reasonably solid performance over the past three years. Of course, one might be skeptical of the ’06 and ’07 results given the operating environment at that time; however. Their results held up in 2008, as well. What that suggests to me is that the Bank of Hampton Roads has a higher quality loan portfolio and they are mostly concerned with issues plaguing banks across the nation right now, such as high unemployment spurring a greater number of delinquencies.

If the Bank of Hampton Roads is in reasonably good shape once we escape the current environment, then what’s the potential of the new combined entity? That’s a much more difficult question to answer unfortunately because we only have two quarters worth of data. One positive thing to note off the bat is that HMPR’s net interest margin for the most recent quarter is healthy at 3.8%.

The following chart shows 1st Half earnings for HMPR in 2009 and 2008 (pre-acquisitions):

You can see revenues have skyrocketed for the combined entity. You might also notice that earnings look terrible. It’s enough to frighten away most investors. But one should analyze those earnings a bit before becoming mortified.

Notice what I highlighted with blue and yellow. It’s the provision for loan losses by percentage and also goodwill impairment. This has a dramatic impact on the proclaimed earnings. The problem with these measures is that they look at the past, more than the present, and future. Goodwill impairment is a non-cash charge. The provision measures probable losses from loans made throughout the years, during an extremely dismal economic environment. It does not realistically measure the default rate on outstanding loans originated this quarter. If it did, this bank would have been out of business a long time ago.

Below is my attempt to create a model for more “Normalized Earnings.” There are difficulties in doing this, but a slightly-flawed model is better than no model. The green column represents my somewhat arbitrary attempt to single out a “most probable” earnings.

This model incorporates data for the first two quarters of 2009 only. Notice that I created a second set of earnings figures in case of further dilution (which seems likely). However, these earnings figures might not be a truly meaningful estimate of “earnings potential” for HMPR given the recent merger. What is particularly interesting if that even if I use the 3rd Quarter data (which shows some improvements over Q1 and Q2), the results look a slight bit better:

These seemingly minor improvements might actually be a very good sign for HMPR. The combined entity could still see further cost savings in the future and there was strong deposit growth in the 3rd Quarter. Combine that with HMPR’s high net interest margins and this company would appear to have significant earnings potential.

One final thing to note on this front --- HMPR’s cash flows for the 2nd Quarter actually looked good:

The basic point I’m driving at here is that HMPR is a fairly profitable bank, with an OK balance sheet, and good growth prospects and it’s selling as if it will be bankrupt within the next year. While I wouldn’t completely rule this possibility out, it is also possible that the market is overreacting.

Valuation

So what’s HMPR worth? It’s difficult to say for sure, but it seems to me that there is a very high likelihood that it’s worth more $2 per share. From a somewhat conservative valuation perspective, I would say it’s worth $5 - $12. I base this off a future earnings potential that might be around 30 cents to 80 cents per share on an annual basis. This might be a fairly conservative synopsis, but given the high risks in the commercial bank sector, this sounds reasonable for now.

If you believe HMPR’s portfolio is in relatively good shape and their current allowance is adequate; plus, you believe they will continue to grow, this could be worth upwards of $20 per share. Don’t get too excited about that figure, though, because that’s probably very optimistic. I am merely suggesting that there is a strong potential upside with HMPR.

On the flip side, HMPR’s brief attempt at raising capital last summer, coupled with their participation in TARP should give some legitimate signs of concern. It’s unclear why HMPR wanted to raise capital. Insiders had been buying in substantially before that time period, which is perplexing given the brief equity offering. It’s possible that HMPR wanted to raise more cash to buy more distressed banks and/or expand their presence in the mid-Atlantic region, but changed its mind as equity prices for commercial banks continued to nosedive during the late summer. The recent earnings call suggests that executives at HMPR do plan on raising more capital in the future, but not until the price of their stock is more reasonable. My hope is that HMPR does not raise more capital until the stock price hits at least the $6 - $7 range.

Conclusions

I don’t know that all the banks that I am buying will survive; but I am betting that the returns from the winners will be greater than the losses from the losers. It will take patience, a strong will, and dedication to reap those rewards, as it may take 2-5 years before it starts to become obvious to mainstream investors that banks that they once believed were teetering on the edge of bankruptcy actually have very strong earnings potential moving forward. In the meantime, it’s completely possible that a company like HMPR could lose another 70% of its value.

I have bought into HMPR for my personal portfolio and a fund I manage. I jumped in around $2 - $2.20, so I have a reasonable margin of safety here. Potential gains could be anywhere from 100% to 1000%. The risk-reward balance appears very favorable for the long side and that’s why I believe this is a good pick-up. While the balance sheet could be better, the growth and earnings potential makes HMPR particularly interesting.

"Note that “Total Liabilities” are about 90.2% of “Total Assets”, with about 2.2% being in “Intangible Assets.” After discounting intangibles, the Liability to Tangible Assets ratio is about 92.3%. This is a bit higher than I would like to see, but about par for the course when it comes to commercial banks."

I don't follow bank stocks, but this ratio isn't much lower than most of the banks that the FDIC has closed over the last several months. Couldn't a relatively small increase in defaults cause the bank to fail?

I don't follow bank stocks, but this ratio isn't much lower than most of the banks that the FDIC has closed over the last several months. Couldn't a relatively small increase in defaults cause the bank to fail?

Actually, that ratio is a bit better than average.

It would take a moderate increase in defaults for the bank to fail at the very least. Not saying that this is impossible. I don't believe it is likely with this bank, but it could always happen.

Things to consider:

(1) Their loans are mostly concentrated in Raleigh-Durham, Eastern Carolina, Hampton Roads, and Central Virginia; none of which have experienced a huge decrease in RE prices.

(2) HMPR is traded on a major public exchange and if they were in real danger, they would have probably continued on with their offering from earlier this year. The fact that they didn't want to do the offering once the price of their stock dipped below the $6 mark indicates that they have some latitude.

(3) Bank of Hampton Roads and Shore Bank seem to have a very good portfolio quality. Gateway Bank might be slightly more questionable, but I don't see the evidence that they are going to get eaten alive by deterioration in loan quality right now. Once again, I could be wrong.

All this is to say ... there's a reason why I don't recommend going all-in on one particular bank. Diversify holdings if you're buying into these banks, because even if you miss a few issues with one bank, you could find it trading at $0. But if you buy a basket of banks that have favorable risk-reward balances, you can afford to have a few dogs in there.

Nice analysis. If only most investors put this much thought into their stock picks. I have been looking to buy one of the regional banks as well for my real money portfolio and have had a hard time finding anything. I was thinking of First Midwest Bancorp (FMBI).

APJ, I like streetflame's work on the banks. My only problem with most of the banks he is looking at is that they are all .OB/.PK stocks. I don't like buying into stocks with less liquidity.

It's also a significant disadvantage for banks right now, because in the event that they do need to increase their capital in order to (a) survive or (b) comply with FDIC mandates, they are going to have a much more difficult time than their counterparts traded on major public markets.

Not saying I want to buy into a bank and then see a dilutive offering, but I'd rather see an offering that dilutes the value of the stock rather than a bank failure that makes the stock go to $0.

Yes, the stocks with less liquidity do carry a higher risk of up/down movements against you & may prevent you from being able to cash out quickly.

I have a point that I'd like to bring up based on your statement. The smaller banks, for the most part, have simpler, more easy-to-read statements where you can assign value to their assets because what you see is what you get. As you get to the larger banks, moving up the chain, the probability increases higher & higher that you'll be faced with a balance sheet with questionable invested securities or other assets that are difficult to value & also off balance sheet contingincies that would also be difficult to value.

With that point, it is easier to determine which of the smaller banks would most likely have no need to access more capital & which banks would need capital. As you move up the chain, it becomes harder to differentiate the point unless if you 'guess' based on what the market prices its stock at...which could be dangerous.

Current banks failed, put through FDIC receivorship is somewhere around 120 in this cycle. You can expect to see 200+ more in the next year. And yes, the majority of these will be the smaller banks but there is a great majority of these same, smaller regional banks that will remain untouched & clean. & some lucky ones that will grow on the cheap through acquisitions of closed banks.

APJ, I completely agree with you. In fact, that was precisely the point in my article; to look into small cap banks. I just like small cap and micro cap banks that are traded on major public markets. Not a big fan of low liquidity instruments. Moreover, I'm not even allowed to buy them for the fund I manage.

Not really. MTB is too big and heavily followed to pique my interest much. Of the larger banks, it probably is one of the highest quality ones, however. But I'm not sure if my opinion on that means much.

It's reassuring at least- I bought at 70 after Lehman and doubled-down on the margin in late February this year (now mostly paid off). I'm young so I felt comfortable with the wipeout risk. It came close.